Fitch ratings says a decline in Cypriot banks’ non-performing exposures “significantly reduces” contingent liabilities to the sovereign, but the banking sector “remains weak” and further reduction of bad loans would partly depend on the effective use of legal tools.

Data released by the Central Bank of Cyprus in January showed that NPEs fell to €11 bln at end-3Q18, or 32% of total gross facilities, from €16.6 bln (40%) at end-1H18.

Fitch said this “is broadly consistent with our expectation at our most recent sovereign rating review in October 2018, when we upgraded Cyprus to `BBB-`/Stable.”

The 3Q drop, the ratings agency said, “was mainly driven by the transfer to Cyprus Asset Management Company (KEDIPES) of Cyprus Cooperative Bank`s (CCB) €5.7 bln NPEs portfolio, as well as sales of loans, reclassification of restructured loans as performing, debt-to-asset swaps, write-offs and loan repayments, according to the central bank.”

The NPE ratio, it added, “previously declined from 44% at end-2017 (one of the highest among Fitch-rated sovereigns) due to the securitisation of €2.7bln gross NPEs by Bank of Cyprus - the country`s first large-scale NPE securitisation.”

“Improving the overall health of banks by lowering NPEs reduces contingent liabilities stemming from the sector.”

“Some costs to the sovereign have already been realised - for example when €3.19 bln of government bonds were placed into CCB to facilitate the sale of performing assets to Hellenic Bank (HB), causing a one-off increase in debt-to-GDP last year.”

“Additional fiscal costs could arise from the government-guaranteed Asset Protection Scheme covering unexpected losses on €2.6 bln of the assets acquired by HB.” An independent assessment, it says, has estimated that actual losses could amount to €155 mln.

Fitch pointed out that Cyprus`s banking sector is “still burdened by a high stock of problem assets (average NPL ratios in EU members are around 4%), weighing on banks` profitability and internal capital generation as well as on capital at risk from unreserved NPEs.”

“Further clean-ups would free up capital to support new lending,” it added.

The ratings agency estimated that “a supportive economic environment along with increased institutional investor appetite for Cypriot distressed assets could encourage more securitisations.”

“Measures introduced in July 2018, in particular a more efficient foreclosure framework, could also help sustain momentum in the decline of NPEs, although its effectiveness is still not fully tested.”

Fitch said private sector debt, “although declining fast” it is “another drag on the economy and a constraint on credit growth.”

In 3Q 2018 private-sector debt stood at 215% of GDP, excluding special purpose entities, of which slightly more than half was corporate debt.“The macroeconomic backdrop should bolster further private sector deleveraging as well as NPE resolution,” Fitch said.

It added that “a dynamic labour market, a pick-up in residential property prices, wage increases, and the ESTIA scheme may foster repayments.”